Feature

The Underestimated Anti-Amazon

Once a books powerhouse, Barnes & Noble is now a hidden gem, with 64% of retail shelf space for books, growing same-store sales and a quarter of the e-book market. Why the shares could be worth twice their current quote.

Barnes & Noble (BKS) shares trade around $15, down from an April peak of $26 when
Microsoftmsft 1.0162268480576955%Microsoft Corp.U.S.: NasdaqUSD61.63
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(MSFT) announced a $300 million investment in the Nook division. A sum-of-the-parts analysis, based in part on a report from the little-known New York firm Icerose Capital, suggests the shares could be worth twice that.

Wal-Mart and Target tossed out Amazon.com's Kindle in favor of Barnes & Noble's Nook, giving it a boost in a market where it's already strong.
David Paul Morris/Bloomberg News

The retail business alone could be worth the entire stock price, meaning investors are paying little or nothing for the newly formed Nook Media division, which includes both Nook and Barnes & Noble's profitable college unit that runs 667 bookstores on campuses around the country.

Barnes & Noble has substantial sales for a company with a market value under $900 million. It should generate $5 billion from retail and $3 billion from Nook Media this fiscal year. That has not been overlooked by savvy media investor John Malone. His
Liberty Medialmca 0.7575757575757576%Liberty Media Corp. Series A Liberty MediaU.S.: Nasdaq31.255
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(LMCA) owns $204 million of Barnes & Noble preferred stock that converts at $17 a share. Liberty offered to buy the entire company last year for $17 a share.

Barnes & Noble is expected to lose 73 cents a share in its current fiscal year, ending in April 2013, after losing $1.41 in fiscal 2012. However, the red ink reflects losses at the Nook division as it seeks to gain market share. Nook, with 27% of e-book sales, is second to Amazon, and it's the leader in digital magazine subscriptions.

CEO William Lynch laid out the bull case at Liberty Media's investor day earlier this month. With the demise of rival bookseller Borders, B&N is dominant with "64% of the total shelf space at brick-and-mortar" retailers, he said. "Barnes & Noble has become the only place in America to shop for a decent selection of physical books." And physical books, "aren't going away anytime soon."

The retail division's pretax cash flow rose to $317 million in fiscal 2012 from $259 million in the prior year. Cash flow was $75 million in the July quarter, up 88% from a year earlier, as comparable-store sales rose 4.6%, helped by strong sales of the erotic trilogy, Fifty Shades of Grey. Icerose projects $379 million of retail cash flow this year and about $3 a share in free cash.

The retail business could be worth $820 million, or $14 a share, if its projected cash flow is valued at a modest 3.5 multiple—and its roughly $500 million in debt and preferred is subtracted from that amount.

The Nook division is tougher to value. Microsoft paid $300 million for a 17.6% stake, which implies a total value of $1.7 billion. Barnes & Noble's 82.4% stake therefore would be worth $1.4 billion, or $24 a share. This suggests a total value for the company of about $38 and explains why the stock price ran up to $26 after the Microsoft deal.

The shares have drifted down as the Nook division reported sizable losses amid doubts about whether the Nook can remain competitive against Amazon's Kindle, Apple's iPad and other tablets. Most analysts won't credit Barnes & Noble with the full Nook value implied by the Microsoft investment, but Nook probably is worth a good deal more than its current implied value of zero.

The good news for investors is that Barnes & Noble has separately capitalized the Nook division with the Microsoft investment and doesn't intend to plow retailing profits into it. Microsoft plans to invest another $305 million into the Nook unit in the next five years. Two new well-reviewed Nook devices go on sale this week.

The Bottom Line

Barnes & Noble's shares could be worth twice their recent price, based on the value of the company's Nook e-reader and its profitable bricks-and-mortar stores.

Two bullish developments could occur in the next year: a sizable dividend and a Nook spinoff. While Lynch has been noncommittal on both, the company seems to be moving in that direction. Barnes & Noble could pay a $1 a share dividend, for a 6.7% yield, based on the retail business's free cash flow. There is now no dividend.